Excluding Workers by Classification

(Posted June 4, 2002)

Question 192:In Q&A 190 you give an example of Zeke, a retired executive on a consulting agreement. He's paid as in independent contractor but he's still legally an employee. Would it be possible for the employer to define an acceptable class of employees to be excluded from the qualified plan so that Zeke would be considered as having changed to an excluded class of employment? If so, what might the class be called?

Answer: Absolutely he can be excluded. There is no reason why the plan couldn't provide that anyone who receives a 1099 and not a W-2 from the company is excluded.

I say that because of a Technical Advice Memo written by Mr. Richard Wickersham of the IRS. Although it was never issued a formal number, it is still a valid analysis of the situation. I've posted it in the Who's the Employer Reading Room. Let me quote a few of the pertinent paragraphs:

Many employers have amended their retirement plans in the wake of this decision in an attempt to protect their plans against the uncertainty that may be created by retroactive determinations that workers are employees rather than independent contractor. Typically, such amendments provide that workers engaged as independent contractors, or workers not paid through the payroll system, will not be eligible to participate in the plan, even if the classification as an independent contractor is later determined to be erroneous.

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As indicated previously, employers have legitimate reasons to exclude from plans workers who were not engaged as common law employees. If the worker is in fact, an Independent [sic] contractor, the employer would be precluded from covering the individual under its plan, absent some specific statutory rule, such as the individual's status as a based employee under section 414(n) of the Code. Even if the worker is not, in fact, an independent contractor, the employer has a legitimate business interest in knowing the cost of the worker's compensation package at the time the worker is engaged.

A tax-qualified retirement plan that conditions participation on status as a common law employee need not define that term, for the standard articulated in Darden will be applicable absent some special definition in the plan. With respect to the case at issue, section 410(a) of the Code does not preclude a qualified plan from excluding retroactively reclassified employees from participating in the plan. A worker's status is based on facts and circumstances. Making a determination as to whether a common law employment relationship exists is not always straightforward. An employer, making the initial classification of a worker's status, has legitimate concerns in protecting its plan from the consequences of retroactive reclassifications if a mistake is made. Nothing in section 410(a) prevents an employer from addressing these concerns though preventative measures similar to the plan language provided by the taxpayer.

Of course, common law employees excluded through such a clause will be counted in determining whether the plan satisfies IRC sections 410(b) and 401(a)(26). However, assuming you can pass those hurdles after the exclusion, there is no problem with excluding workers who are not actually on the company's W-2 payroll.

For further discussion of this TAM and the exclusion of employees, see Chapter 2 of my book Who's the Employer.

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